The transmission mechanism of monetary policy

Introduction and summary The Monetary Policy Committee (MPC) sets the short-term interest rate at which the Bank of England deals with the money markets.interest rate affect economic activity and inflation through several channels, transmission mechanism official interest rate decisions affect market interest rates (such as mortgage rates and bank deposit rates), to varying degrees. same time affect expectations these changes in turn affect the spending, saving and investment behaviour of individuals and firms in the economy. Third, the level of demand relative to domestic supply capacityin the labour market and elsewhereis a key influence on domestic inflationary pressure. For example, if demand for labour exceeds the supply available, there will tend to be upward pressure on wage increases, which some firms may be able to pass through into higher prices charged to consumers. Fourth, exchange rate movements have a direct effect, though often delayed, on the domestic prices of imported goods and services, and an indirect effect on the prices of those goods and services that compete with imports or use imported inputs, and hence on the component of overall inflation that is imported. I Links in the chain Monetary policy works largely via its influence on aggregate demand in the economy., in the long run,monetary policy determines the nominal or money values of goods and servicesthat is, the general price level. From a change in the official rate to other financial and asset markets A central bank derives the power to determine a specific interest rate in the wholesale money markets from the fact that it is the monopoly supplier of high-powered money,which is also known as base money.(1) Bank chooses the price at which it will lend high-powered money to private sector institutions. In the United Kingdom, the Bank lends predominantly through gilt sale and repurchase agreements (repo) at the two-week maturity. This repo rate is the official rate mentioned above. Short-term interest rates A change in the official rate is immediately transmitted to other short-term market rates, both to money-market (rates on repo contracts ,interbank deposits. banks adjust their standard lending rates (base rates), usually by the exact amount of the policy change. affects interest rates banks for variable-rate loans, Long-term interest rates the impact on longer-term interest ratescan go either way. As are influenced by an average of current and expected future short-term rates, . A rise in the official rate could, for example, generate an expectation of lower future interest rates, in which case long rates might fall in response to an official rate rise. Asset prices affect the market value of securities, such as bonds and equities. The price of bonds is inversely related to the long-term interest rate, so a rise in long-term interest rates lowers bond prices, higher interest rates also lower other securities prices, such as equities. This is because expected future returns are discounted by a larger factor, The exchange rate also affect the exchange rate. The exchange rate is the relative price of domestic and foreign money, . The precise impact on exchange rates is uncertain, as it will depend on expectations about domestic and foreign interest rates and inflation, . However, an unexpected rise in the official rate will probably lead to an immediate appreciation of the domestic currency in foreign exchange markets, and vice Expectations and confidence Official rate changes can influence expectations about the future course of real activity in the economy, Such changes in perception will affect participants in financial markets, and , changes in expected future labour income, unemployment, sales and profits. The direction in which such effects work is hard to predict, and can vary from time to time. From financial markets to spending behaviour Individuals

Individuals affected by monetary policy change inseveral ways. There are three direct effects. First, they facenew rates of interest on their savings and debts. disposable incomes of savers and borrowers alter, as does the incentive to save rather than consume now. Second, the value of individuals financial wealth changes as a result of changes in asset prices. Third, any exchange rate adjustment changes the relative prices of goods and services priced in domestic and foreign currency. . How the Bank sets interest rates The Bank implements monetary policy by lending to themoney market at the official repo rate chosen by the MPC. The Banks dealing rate changes only when the MPC decides that it should. Arbitrage between markets ensures that the MPCs decisions are reflected across the spectrum of short-term sterling markets. interest rates charged on these, and higher rates will tend to economic activity, this is likely to increase confidence and expectations of future employment and earnings growth, leading to higher spending Exchange rate changes can also affect the level of spending by individuals. Firms An increase in the official interest rate will have a direct effect on all firms that rely on bank borrowing or on loans of any kind linked to short-term money-market interest rates. A rise in interest rates increases borrowing costs (and ice versa for a fall). The reduces the profits of such firms and increases the return that firms will require from new investment projects, making it less likely that they will start them In contrast, when interest rates are falling, it is cheaper for firms to finance investment in new plant and equipment, and more likely that they will expand their labour force. . From changes in spending behaviour to GDP and inflation All of the changes in individuals and firms behaviour discussed above, when added up across the whole economy, generate changes in aggregate spending. Second-round effects We have set out above how a change in the official interest rate affects the spending behaviour of individuals and firms. The resulting change in spending in aggregate will then have further effects on other agents Time-lags Any change in the official rate takes time to have its fullimpact on the economy. It was stated above that a monetary policy change affects other wholesale money-market interestrates and sterling financial asset prices very quickly, but theimpact on some retail interest rates may be much slower. In some cases, it may be several months before higher official rates affect the payments made by some mortgage-holders (or received by savings deposit-holders). It may be even longer before changes in their mortgage payments (or income from savings) lead to changes in their spending in the shops. Changes in consumer spending not fully anticipated by firms affect retailers inventories, and this then leads to changes in orders from distributors. Changes in distributors orders then affect producers inventories, and when these become unusually large or small, production changes follow, which in turn lead to employment and earnings changes. These then feed into further consumer spending changes. All this takes time. it takes up to about one year in this and other industrial economies for the response to a monetary policy change to have its peak effect on demand and production, and that it takes up to a further year for these activity changes to have their fullest impact on the inflation rate. This slow adjustment involves both delays in changing real spending decisions, as discussed above, and delays in adjusting wages and prices, to which we turn next. GDP and inflation In the long run, real GDP grows as a result of supply-side factors in the economy, such as technical progress, capital accumulation, and the size and quality of the labour force. Some government policies may be able to influence these supply-side factors, but monetary policy generally cannot do so directly, There is always some level of national output at which firms in the economy would be working at their normal-capacity output, and would be under no pressure to change output or product prices faster than at the expected rate of inflation. This is called the potential level of GDP. When actual GDP is at potential, production levels are such as to impart no upward or downward pressures on output price inflation in goods markets, and employment levels are such that there is no upward pressure on unit cost growth from earnings growth in labour markets. There is a broad balance

between the demand for, and supply of, domestic output. The difference between actual GDP and potential GDP is known as the output gap. When there is a positive output gap, a high level of aggregate demand has taken actual output to a level above its sustainable level, and firms are working above their normal-capacity levels. is also likely to increase domestic inflationary pressures Some firms may also feel the need to attract more employees, and/or increase hours worked by existing employees, to support their extra production. This extra demand for labour and improved employment prospects will be associated with upward pressure on money wage growth and price inflation . So booms in the economy that take the level of output significantly above its potential level are usually followed by a pick-up of inflation, and recessions that take the level of output below its potential are generally associated with a reduction in inflationary pressure.The output gap cannot be measured with much precision. Holding real GDP at its potential level would in theory (in the absence of external shocks) be sufficient to maintain the inflation rate at its target level only if this were the inflation rate expected to occur by the agents in the economy. So holding output at its potential level, if maintained, could in theory be consistent with a high and stable inflation rate, as well as a low and stable one. The level at which inflation ultimately stabilises is determined by the monetary policy actions of the central bank and the credibility of the inflation target. In the shorter run, the level of inflation when output is at potential will depend on the level of inflation expectations, and other factors that impart inertia to the inflation rate. Inflation expectations and real interest rates . Inflation expectations matter in two important areas. First, they influence the level of real interest rates and so determine the impact of any specific nominal interest rate. Second, they influence price and money wage-setting and so feed through into actual inflation in subsequent periods. We discuss each of these in turn.The real interest rate is approximately equal to the nominal interest rate minus the expected inflation rate. The real interest rate matters because rational agents who are not creditconstrained will typically base their investment and saving decisions on real rather than nominal interest rates. This is because they are making comparisons between what they consume today and what they hope to consume in the future. It is only by considering the level of real interest rates that it is possible, even in principle, to assess whether any given nominal interest rate represents a relatively tight or loose monetary policy stance. For example, if expected inflation were 10%, then a nominal interest rate of 10% would represent a real interest rate of zero, whereas if expected inflation were 3%, a nominal interest rate of 10% would imply a real interest rate of 7%. So for given inflation expectations, changes in nominal and real interest rates are equivalent; but if inflation expectations are changing, the distinction becomes important The role of money So far, we have discussed how monetary policy changes affect output and inflation, with barely a mention of the quantity of money. (The entire discussion has been about the price of borrowing or lending money, ie the interest rate.) This may seem to be at variance with the well known dictum that inflation is always and everywhere a monetary phenomenon. It is also rather different from the expositions found in many textbooks that explain the transmission mechanism as working through policy-induced changes in the money supply, which then create excess demand or supply of money that in turn leads, via changes in short-term interest rates, to spending and price-level changes. The money supply does play an important role in thetransmission mechanism but it is not, under the United Kingdoms monetary arrangements, a policy instrument Suppose that monetary policy has been relaxed by the implementation of a cut in the official interest rate. Commercial banks correspondingly reduce the interest rates they charge on their loans. This is likely to lead to an increased demand for loans (partly to finance the extra spending discussed above), and an increased extension of loans by banks creates new bank deposits that will be measured as an increase in the broad money supply (M4). So the change in spending by individuals and firms that results from a monetary policy change will also be accompanied by a change in both bank lending and bank deposits. Increases in retail sales are also likely to be associated with an increased demand for notes and coin in circulation